Bank Results Show Strength Even Before Mark-to-Market

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Accounting changes aimed at helping the balance sheets of banks with toxic assets appear to be providing little or no help so far with earnings reports.

The accounting rules, known as mark-to-market, were amended so that banks stuck with underperforming assets—particularly mortgage and other credit-related securities—could value them at their future projected worth and not at current value.

But the early earnings are showing that the rules probably won't be reflected until second-quarter results are reported. And that has some investors hoping that financial earnings, which have been better-than-expected so far, will do even better once market-to-market accounting takes effect.

"I hope we're going to see the financial system on an upward track," says former FDIC Chairman Bill Isaac, who helped draft the rule changes. "It's probably not going to be a straight line for all institutions. There will be some varied results. We are in a very favorable climate right now for banking institutions because they're cost of funding is so low."

Though the cost of lending for banks is near zero, a strong effort to reduce debt among financial firms and with the mark-to-market changes is providing an uncertain earnings environment.

"We have an accounting rule change and we're in the middle of the transition," David Kotok, chief investment officer at Cumberland Advisors, told CNBC. "We won't know the eventual impact of that until the June 30 quarter."

Indeed, General Electric in its earnings report said it had not applied the accounting changes toward its first-quarter results, but will show an impact for the second quarter. GE (NYSE: GE) is the parent corporation for CNBC.com.

Investors hope that the changes in accounting, plus aggressive cost-containment, will help improve the Dow component's balance sheet.

"We are aggressively managing our cost structure to respond to challenging global economic conditions," GE CEO Jeff Immelt said in a statement. "For 2009, we will reduce our costs by more than $5 billion. We've reduced headcount and are managing company operations more efficiently, leading to improved operating leverage in our infrastructure businesses."

But there was also some fear this week that even when the changes do take complete hold, they may not help as much as hoped.

State Street (NYSE: STT) shares surged immediately after the Financial Accounting Services Board announced the rules changes on April 1, a day after public comment ended. But the stock has backed off a bit after earnings from JPMorgan were taken as a sign that the changes might not help as much as hoped.

"State Street was perceived to be a large beneficiary of the accounting rule changes, and now the market may be concluding that it overestimated that effect a little bit," Murali Gopal, analyst at Keefe, Bruyette & Woods, told Reuters.

Moreover, there's still some concern that the FASB changes didn't go far enough. The rules still provide that the bad assets be deducted from capital, though not from earnings.

Isaac said if that rule also isn't repealed it could mean more trouble for banks later because it puts a tax burden on banks getting hit by the losses.

"If we can get this mark-to-market stuff behind us, I believe this industry will recovery very quickly," he said. "I would hope we would stop charging mark-to-market losses against capital. We wouldn't be in this mess if we weren't making hundreds of billions in dollars on charges."

Earnings from GE and other financial-related companies, including Citigroup (NYSE: GE) and JPMorgan Chase (NYSE: GE), generally beat analyst estimates. That added to hopes that those companies would show better second-quarter results once mark-to-market changes took hold.

Under the mark-to-market rules, firms holding the assets were forced to price them at current bids that could be well under the assets' values should they be held to duration. The assets are under pressure because of falling property values used as collateral for the various securities, as well as soaring default and foreclosure rates.

"Sometimes today's price doesn't reflect the reality of one's business operation, so I'm sympathetic to the idea of turning off the requirement in carefully limited cases," said Matt Gelfand, chief investment officer at Lynx Investment Advisory in Washington, D.C. "If turning off the mark-to-market helps to reflect a more practical reality, than that actually results in more accurate report and would be helpful to earnings to an extent that businesses can report on a more traditional GAAP basis."

But simply changing the value of the asset does not change the problems with its underlying components, and Gelfand warns that the adjustments do not cure all the ills that financial companies face.

"A good analyst is going to be able to make the appropriate adjustments," Gelfand said. "While it could affect the reported earnings--the headline number--I don't know that it would affect the assessment of any one analyst of the corporation they are reviewing."